We derive an explicit solution to the portfolio problem of a power utility investor
with preferences for wealth at a ¯nite investment horizon. The investor can invest
in assets with return dynamics described as part of a general multivariate model.
The modeling framework encompasses discrete-time VAR-models where some of
the state-variables (e.g. expected excess returns) may not be directly observable.
A realistic multivariate model is estimated and applied to analyze the portfolio
implications of investment horizon and return predictability when real interest rates
and expected excess returns on stock and bonds are not directly observed but must
be estimated as part of the problem faced by the investor. The solution exhibits
small variability in portfolio allocations over time compared to the case when excess
returns are assumed observable.
JEL Classification: G11
Keywords: Portfolio choice, predictability, VAR, unobserved state-variables, hedging demands